10/01/2024
Why “Fat Protocol Thesis” no longer works in the current crypto environment?
The Fat Protocol Thesis did a huge disservice to the field and set us back years.
In fact, I really enjoyed Fat Protocol Thesis and highly recommend you read it if you haven't already.
The simple version of this theory is that protocols (e.g. blockchain) will capture more value than the applications built on them. Why? Partly because crypto apps have a weaker moat (they are easily replicated). But the main reason is that the success of the apps will drive users to accumulate protocol tokens in order to use them, thus creating a network effect for the blockchain as each app pushes up the price of the tokens of the chain it is built on.
In 2016, this is a very forward-looking argument. I'd also like to add my perspective on why protocols can be of greater value than apps: protocol tokens are akin to the national currency of a digital nation, not only acting as a medium of exchange, but also representing a legal order (smart contract) that guarantees the validity of transactions, while collecting “taxes” for the ecosystem. Applications, on the other hand, are usually just ordinary business entities that generate revenue.
Of course, the market capitalization of a currency is usually highly correlated to the GDP generated by everything built on it, and thus is often much larger than the market capitalization of a company. That's why I think that protocols are usually more valuable than applications.
And therein lies the rub. The last decade has validated the “fat protocol theory” in many ways, culminating in the past year. As we all know, the market capitalization of chains has crushed the market capitalization of applications. Protocols are often funded at hundreds of millions of dollars without a product, while apps with a dedicated user base struggle to raise capital.
To understand the extent to which the market agrees with the “fat protocol theory” - to the point of irrationality - one need only look at the recent valuations of the highly fungible, randomized Layer 2 (L2) chains. ) chain valuations.
These L2s don't fulfill any of the requirements of Fat Protocol Theory because their tokens aren't needed for transactions at all - in fact, they don't even need tokens. But in crypto, where the narrative is often stronger than the logic, many of these L2s easily reach nine-figure valuations, while apps struggle with valuations.
(Of course, I think there are some L2s that will actually have value, like and , but that's another topic.)
We've heard it many times about “chain first”: a blockchain is only as valuable as the applications on it. Chains themselves will say the same thing, emphasizing their huge performance improvements. “Of course we need to expand the block space,” they say, ”because the next top application will need it.” But in a world where apps have been failing for a full decade, very few people still want to build or fund more apps.
It's funny, but unfortunately, the logic of “we need to fund apps to make blockchain successful” will never be enough to get VCs to invest in an entire category that they think will fail. The idea that apps will help make blockchain valuable is appealing, but it's not compelling enough if no one thinks the apps themselves are valuable.
So I'd like to propose a Fat App Thesis. I'd like to point out that throughout the history of the Internet, there's been one argument that's been so true that I think it's even a bit boring: the fact that most of the value in crypto today is in the apps.
There are three reasons, in increasing order of importance:
The first and most speculative reason is simply the historical cycle. Applications are grossly undervalued and protocols are grossly overvalued for the reasons described above. The Internet tends to switch back and forth between ten-year cycles of infrastructure and applications, and we're at the tail end of a massive infrastructure boom in which we created transcendent technologies that finally work (this didn't hold true two years ago). Now is the time for apps to shine, and they have never been more undervalued.
The second, more compelling reason is that apps and protocols have swapped places since the Fat Protocol Theory was introduced in 2016. Back then, apps were mostly fungible forks of each other's tools of the trade, while chains were walled gardens with huge liquidity moats. But things have changed dramatically. Today, apps can't exactly replicate each other (e.g., Sushiswap) because their real moat is users.
At the same time, chains don't even need much liquidity to support future social apps, unless they are targeting DeFi apps that need liquidity (e.g. ). What's more, with the advent of cross-chain solutions and chain abstractions that allow users to seamlessly use apps and bridge across ecosystems without knowledge of the chain being used, liquidity is collapsing as a moat itself for most chains. Today, chains are largely interchangeable - not applications.
But this leads to the third and most important reason:
When mobility is no longer a moat, users are the moat.
Users will congregate where other users are. That's why ultimately only a few apps will win - because users will eventually gravitate to each other in a few unique Internet “cities”.
That's why I suspect that people are so down on apps today (inside and outside of crypto): a few apps won a decade ago, and since then it's hard to compete for their users' attention. Frankly, limited by the constraints of Web2 - notably app store fees, closed APIs, and the inability to spend money easily - it's hard for anyone to come up with new app ideas.
But on-chain technologies are making entirely new app experiences possible, bringing with them an economic and reputational upside that never existed in the past: they eliminate app store fees, open up public blockchain APIs, and make it easy for users to spend and save money. So that's my theory. I believe some of these apps will win out as well. They will be the “super apps” that will take up most of the block space, as the history of the internet has always shown.
I could be wrong, very wrong. This era may be different from the past. We may see millions of mini-apps flourish, like all the apps on Telegram, and I'll be very happy about that.
But I suspect we're in a short-lived era of apps, as the design space for new apps has only just opened up in the last two years - and crypto apps that are built entirely on the “token price up” will end up with a “token price down” as the “token price down”. “token price drop”. We don't talk about this enough, but all signs point to the end of this era. The really exciting thing about crypto apps today is that the next generation of prediction markets, contests, NFC chips, DePINs, and even e-cigarettes no longer rely on token price increases as a use case. For the first time, crypto is a means to an end, not an end in itself.
I mean, apps can actually win in the long run and start taking up all the block space we've been generating for years. So what happens next? These apps can do something innovative. They can incentivize growth by giving money back to users instead of the Apple App Store. They can collect revenue from each click. Ultimately, they can generate huge amounts of revenue, and only a small portion of that will flow to the chain.
I've said before that chains don't need huge revenues to get huge valuations because they should be valued based on something like GDP. But when most of the GDP is generated by a handful of applications, it's worth asking the question: who is really the “fattest”? Is it still the chain? Or is it more likely to be the applications?
Finally, I'd like to say that I'm not pessimistic about chains - not at all. Many chains are not interchangeable, due to their unique virtual machine (VM) or opcode (e.g., , , , ), native incentives (e.g., ), high performance in familiar VMs (, xyz), or license-specific implementations (, ). Applications built on these chains can only be implemented on these chains. Ultimately, even if only a few applications win market share, investing in chains is still the best way to invest in those applications.
We like to think there's a war between infrastructure and applications because they compete for private market dollars. But in reality there is no real value war between the two - they complement each other and cannot survive on their own. On top of that, I suspect that most applications themselves will operate like protocols and become the foundation for others to build upon.
However, despite this, we are not only acting as if there is a war, we are also acting as if the infrastructure has won. We are realizing that this is fatal to infrastructure. But what we need to realize is that this is also a huge missed opportunity.
The next major wave of value will flow to applications, and very few in this ecosystem are willing to take the risk of trying to capture it.
